Service on Finance and Development (Feb09/02)
The crisis increased the awareness that vulnerability to financial contagion and shocks depended in large part on how capital inflows are managed, and that governments may have limited options in addressing the sudden stops and reversals that often mark short-term capital flows.
After a brief interruption,
capital flows to
Rather than tightening
restrictions over capital inflows, most countries in
As a result of these policies, the Asian emerging markets are now much more closely integrated into the international financial system than they were in the run-up to the 1997 crisis. Foreign presence in Asian financial markets has increased not only because of historically high non-resident portfolio inflows, but also because of increased penetration of foreign-owned banks and other financial firms. Net resident outflows have reached unprecedented levels, particularly through portfolio investment rather than direct investment.
This process has resulted in greater fragility of the domestic financial system by contributing to credit, asset and investment bubbles even though payments and reserve positions of many of these countries are strong enough to provide insurance against balance-of-payments and exchange-rate crises of the kind experienced during 1997.
The surge in capital flows made an important contribution both directly and also by giving rise to a rapid liquidity expansion, since central bank interventions in foreign currency markets aiming at preventing currency appreciations could be only partially sterilized.
The closer global financial integration has also inflicted significant costs on Asian emerging markets and made them more susceptible to shocks and contagion from the current global financial turmoil triggered by the sub-prime crisis.
Of the $2.4 trillion
reserves accumulated in
These borrowed reserves are approximately equal to the total external debt of the region. They typically yield a lower return than the borrowing costs. Assuming a moderate 500-basis-point margin between the interest cost on debt and the return on reserves, this would now give an annual carry cost of some $60 billion for the region as a whole.
The increase in the share of foreign assets in national portfolios has also resulted in greater exposure to instability in market valuation of these assets in mature markets as well as exchange rate swings.
Asian economies do not have large direct exposure to securitised assets linked to sub-prime lending, even though some significant losses have been reported in the region. However, they appear to have invested large amounts in debt issued by the United States Government Sponsored Enterprises, including mortgage firms Fannie Mae and Freddie Mac.
Holding by central
banks outside the
Asian emerging markets are hurt by sharp swings in capital flows a lot more than expected. These flows, including bank-related capital, initially kept up after the outbreak of the sub-prime crisis, but with the deepening of the credit crunch, there was first a moderation followed by a sharp decline.
According to the
latest estimates by the
The decline in capital
Net portfolio equity
These institutions had been very active in Asian equity markets in the earlier years. They are now hard hit by the sub-prime crisis, and de-leveraging by them appears to be a main reason for the exit of equity portfolio investment from emerging markets as a whole. Thus, emerging markets are providing liquidity to portfolios managed in the major markets in order to cover their mounting losses and margin calls.
With rapid exit
of foreign capital and global retrenchment of risk appetite, asset bubbles
This cycle in Asian asset markets has many features reminiscent of those in the 1990s, but is different in an important respect. In the current cycle, asset deflation is not associated with currency crises and interest rate hikes, but severe trade shocks. The combination of asset deflation with sharp drops in exports and consequent retrenchment in investment can no doubt wreak havoc in the real economy.
This explains why
To contain the impact
of the crisis, it is important to avoid destabilizing feedbacks between
the real and financial sectors, particularly in
Whether or not the
massive fiscal package proposed by the government would prevent such
an outcome remains to be seen. In any event, the challenge faced by
Even though the region as a whole has strong payments and reserve positions, the behaviour of capital flows, including resident outflows, is likely to continue to exert a strong influence on the space available for policy response to external shocks from the sub-prime crisis and hence the performance of several economies of the region.
Because of the sharp slowdown in total capital flows and reversal of portfolio flows, several currencies that had faced constant upward pressure against the dollar (and the yuan) after 2003, particularly the Indian rupee, Korean won and Thai baht, have been falling sharply against both currencies since summer 2008.
Given strong deflationary impulses from the crisis, this may be viewed as a welcome development, and unlike 1997, governments now seem to be wary of throwing all their reserves into stabilizing their currencies.
However, in some
of these countries, notably
Thus, the lessons learned from the 1997 crisis and strong payments and reserve positions do not appear to be protecting the countries in the region against shocks and contagion from the sub-prime crisis. This experience shows once again that when policies falter in managing financial integration and capital flows, there is no limit to the damage that international finance can inflict on an economy.
(* Yilmaz Akyuz
is Former Director, Division on Globalization and Development Strategies,